UNITED STATES SECURITIES AND EXCHANGE COMMISSION
For the quarterly period ended June 30, 2004
OR
For the transition period from ________ to ________
Commission File Number 1-1023
THE MCGRAW-HILL COMPANIES, INC.
Registrant’s telephone number, including area code (212) 512-2000
Not Applicable
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES [X] NO [ ]
Indicate by check mark whether the Registrant is an accelerated filer.
On June 16, 2004 there were approximately 190.0 million shares of common stock (par value $1.00 per share) outstanding.
The McGraw-Hill Companies, Inc.
TABLE OF CONTENTS
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Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholdersof The McGraw-Hill Companies, Inc.
We have reviewed the consolidated balance sheet of The McGraw-Hill Companies, Inc., as of June 30, 2004, and the related consolidated statements of income for the three-month and six-month periods ended June 30, 2004 and 2003, and the consolidated statements of cash flows for the six-month periods ended June 30, 2004 and 2003. These financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the consolidated interim financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of The McGraw-Hill Companies, Inc. as of December 31, 2003, and the related consolidated statements of income, shareholders’ equity, and cash flows for the year then ended, not presented herein, and in our report dated January 27, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2003, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
Ernst & Young LLP
July 27, 2004
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Part IFinancial Information
Item 1. Financial Statements
Consolidated Statement of Income
Periods Ended June 30, 2004 and 2003
See accompanying notes.
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Consolidated Balance Sheet
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Consolidated Statement of Cash Flows
For the Six Months Ended June 30, 2004 and 2003
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Notes to Consolidated Financial Statements
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3. Segment and Related Information
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The McGraw-Hill Companies, Inc.Notes to Consolidated Financial Statements
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Results of Operations - Comparing Three Months Ended June 30, 2004 and 2003
Consolidated Review
The Segment Review that follows is incorporated herein by reference.
In the second quarter of 2004, the Company achieved growth in revenue and income from continuing operations. Revenue growth of 5.0% outpaced a 2.0% increase in expenses. Revenue for the second quarter increased $58.3 million to $1.2 billion. Favorable foreign exchange rates contributed $8.3 million to revenue and had a slightly favorable impact on income from continuing operations.
The revenue increase is primarily attributable to growth in the Financial Services segment. Product revenue decreased by $18.1 million as compared to the prior year’s second quarter, primarily due to a decrease in revenue at McGraw-Hill Education. The segment’s performance reflects a decrease in adoption opportunities in 2004 compared to 2003. The quarter also reflects the seasonal nature of the Company’s educational publishing operations, with the first half of the year being the least significant. Service revenue increased by $76.3 million, an increase of 12.9%, as compared to the prior year’s second quarter, due primarily to the growth in Financial Services. Strong growth in structured finance and corporate finance ratings (corporate finance and financial services) reflect continued favorable market conditions, including a low interest rate environment.
In January 2004, the Company sold Landoll, Frank Schaffer and the related juvenile retail publishing businesses (juvenile retail publishing business), part of the McGraw-Hill Education segment’s School Education Group. The juvenile retail publishing business produced consumer-oriented learning products for sale through educational dealers, mass merchandisers, bookstores and e-commerce. As a result of the Company’s disposition of the juvenile retail publishing business, the results of these businesses are reflected as discontinued operations for all periods presented. The revenue impact for the second quarter of 2003 for the juvenile retail publishing business was $18.5 million.
These businesses were selected for divestiture as they no longer fit within the Company’s strategic plans. The market was considered to have limited future growth potential, possessed unique sales channels, had low profit margins and would have required significant investment to achieve a limited growth potential.
Total expenses in the second quarter of 2004 increased 2.0% primarily due to growth in the Financial Services segment. Product operating related expenses decreased 2.5%, due to cost containment programs at McGraw-Hill Education. Product operating related expenses include the amortization of prepublication costs of $72.5 million, which increased by $4.4 million as compared with the second quarter of 2003. Service operating related expenses increased 4.1% due primarily to growth in the Financial Services segment. Selling and general expenses increased 3.7%. Included in selling and general expenses is a credit of approximately $4.3 million relating to the sale leaseback accounting for the divestiture of the Company’s interest in Rock-McGraw, Inc. (See Note 12). In addition, general corporate expense increased $8.7 million as a result of an increase in vacant space, which is expansion rental space retained at corporate and expenses relating to professional fees for various corporate initiatives. Selling and general product expenses decreased 2.6% primarily as a result of cost containment efforts at McGraw-Hill Education. Selling and general service expenses increased $22.4 million or 11.0% from the second quarter of 2003, primarily from the growth of the Financial Services segment. The Financial Services segment also incurred increased rent expense in the second quarter as a result of its move to London’s Canary Wharf. Also contributing to the
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increase in expense is the decline in pension income from the Company’s U.S. retirement plans. The decline in stock market performance for the 2000 through 2002 period has negatively impacted the return on the Company’s pension assets. Effective January 1, 2004, the Company changed its retirement plans discount rate assumption to 6.25% from 6.75% in 2003. The effect of these changes was a reduction in pension income for the three months ended June 30, 2004 was $3.3 million pre-tax, or 1 cent per diluted share.
Other income for the second quarter of 2003 includes $4.0 million of income from the Company’s 45% equity investment in Rock-McGraw, Inc. which was disposed of in December 2003. Additionally, amounts previously categorized as other income-net within operating expense have been reclassified to the product and service captions to more accurately reflect their nature.
Interest expense decreased 19.2% to $2.2 million from $2.7 million in the second quarter of 2003. The primary reason for the decrease is the reduction in debt. There was no commercial paper outstanding for the three months ended June 30, 2004. In the same period in 2003, average commercial paper borrowings were $562.6 million. The average interest rate on commercial paper borrowings in 2003 was 1.3%. Included in the 2004 second quarter results is approximately $2.4 million of interest expense related to the sale leaseback of the Company’s headquarters building in New York City (See Note 12). Interest income on higher cash levels represented most of the remaining reduction in interest expense.
Income from continuing operations was $165.6 million, a $22.8 million increase over the second quarter of 2003. Excluded from the 2003 income from continuing operations are the results of the juvenile retail publishing business, which was disposed of during January 2004, and is accounted for as a discontinued operation. The juvenile retail publishing business was part of the McGraw-Hill Education segment.
Loss from discontinued operations for the quarter ended June 30, 2003 was $0.8 million. For the quarter ended June 30, 2003, the juvenile retail publishing business generated revenue of approximately $18.5 million and had negative operating results of $1.2 million.
Net income for the quarter increased 16.6% or $23.6 million over the comparable quarter in the prior year. The provision for taxes as a percent of income before taxes is 37.0% and is consistent with prior year second quarter.
Diluted earnings per share from continuing operations for the quarter were $0.86 versus $0.75 in the prior year. Diluted earnings per share on net income were $0.86 versus $0.74 in the prior year.
Segment Review
McGraw-Hill Education
Revenue for the McGraw-Hill Education segment decreased by $11.5 million to $531.7 million and operating profit was $57.1 million versus $55.6 million in the second quarter of 2003. Foreign exchange benefited revenue $1.5 million and had a immaterial impact on operating profit. The segment’s performance reflects a decrease in adoption opportunities in 2004 compared to 2003 as well as the seasonal nature of the business, with the first half of the year being the least significant.
During 2004, the segment realigned certain product lines between the School Education Group and the Higher Education, Professional and International Group. All years presented have been reclassified. The net revenue reclassification for the second quarter of 2003 was $3.2 million from the School Education Group to the Higher Education, Professional and International Group. The full year 2003 net revenue restatement will be $11.8 million from Higher Education, Professional and International Group to School Education Group.
The Global Transformation Project (GTP), which began in 2002, was successfully launched at certain U.S. business units during the first week
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of April 2004. GTP, which had a pilot launch in Canada in 2003, will support the segment’s global growth objectives, provide technological enhancements to strengthen the infrastructure of management information and customer-centric services, and enable process and production improvements throughout the organization. Expenditures related to GTP were $5.6 million and $13.7 million for the quarters ended June 30, 2004 and 2003, respectively. For the quarters ended June 30, 2004 and 2003, approximately $4.7 million and $7.7 million impacted operating profit, respectively. The total cost of this project is anticipated to be $180.0 million.
The McGraw-Hill School Education Group’s revenue decreased 6.7% or $24.3 million to $340.2 million as compared to the second quarter of 2003. The decrease from prior year is a result of the adoption opportunities available and size and timing of open territory opportunities. In 2004, the new adoption market is estimated to be $535 - $540 million for the full year, dropping almost 30% from prior year. Several states have announced increases in educational funding, as it appears that some of the earlier budget issues have been resolved. These states include Alabama, Florida, Kentucky, Tennessee and Virginia. Conversely, some larger districts and some portions of Ohio and Oregon may experience spending cutbacks due to funding issues. Given the limited opportunities offered by this year’s adoption cycle, competition is intense.
The second quarter of 2003 benefited from the North Carolina and Texas middle school and high school social studies adoptions and a large open territory adoption for elementary and middle school math programs in New York City. The New York City second year math purchase is expected in the third quarter of 2004. The School Education Group’s major adoption opportunity in 2004 is in mathematics. During the quarter, the Group’s math products performed well in the middle and high school markets, specifically in the adoption states of Florida and North Carolina. The School Education Group currently has five program offerings in mathematics. All of these programs are performing well with the exception of the K-6 basal offering which is experiencing some softness; however, the Group expects to achieve more than a 30% capture rate for the K-12 math adoptions.
Custom contract testing, which includes a customized assessment program for Qatar, grew in the second quarter contributing to the School Education Group’s growth. The adult education assessment product, the Tests of Adult Basic Education, continued to show a strong performance in the market place. Expenses continued to be negatively impacted by increased scoring requirements for certain custom testing contracts.
McGraw-Hill Higher Education, Professional and International Group’s (HPI) revenue increased by 7.2% to $191.5 million for the second quarter of 2004. The results reflect growth in international sales with school education imprints performing well in Europe and Latin America. The Mexican Education Ministry, through Conaliteg, an official Mexican Government agency, ordered double the number of books than in the previous year, which were delivered in the second quarter of 2004.
Business and Economics; Humanities, Social Science and Language; and Science, Engineering, and Mathematics imprints experienced growth domestically. Humanities, Social Science, and Language performed particularly well on a net sales basis, as these imprints experienced lower return rates than elsewhere in the market. Key titles contributing to the second quarter performance include:
Trade titles gained momentum in the second quarter of 2004 compared to a weak prior year due to the start of the Iraq war in 2003. While the
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computer and technology imprints still experienced softness, some improvement occurred in the latter part of the quarter.
Financial Services
Financial Services’ revenue increased to $504.5 million and operating profit increased $42.6 million to $214.2 million over 2003 second quarter results. Foreign exchange rates contributed $6.6 million to revenue and had a favorable impact on operating profit of $1.3 million.
The Financial Services segment increase in revenue and operating profit is due primarily to the performance of structured finance ratings and corporate finance (corporate finance and financial services) ratings, which represented approximately 64.4% of the growth in revenue. In structured finance the continuing favorable interest rate environment led to strong growth in the issuance of U.S. residential mortgage-backed securities (RMBS) and commercial mortgage-backed issuance (CMBS) both in Europe and the U.S. Collateralized debt obligations (CDOs) experienced strong growth due to improving credit quality and favorable interest rate spreads. Corporate issuance decreased in the second quarter, as issuers have already taken advantage of the favorable interest rate environment to refinance existing debt. Strong corporate earnings and cash flows coupled with excess production capacity have lessened the need for new debt financing. Revenues from recurring fees for surveillance activities and from customers on annual fee arrangements also contributed to the year-to-year increase. In addition, bank loan ratings, counterparty credit ratings and ratings evaluation services experienced higher growth rates than more traditional ratings products and contributed to revenue growth in corporate finance ratings.
Total U.S. structured finance new issue dollar volume increased 37.3%, driven primarily by RMBS issuance, which grew 50.4% according to Harrison Scott Publications. While RMBS issuance was strong in the quarter, the Company expects RMBS issuance to decline toward the end of the year as mortgage rates rise. Issuance for U.S. CDOs increased 58.7% over the prior year due to the favorable interest rate environment. According to Securities Data, U.S. new issue dollar volume for corporate issuers for the second quarter of 2004 decreased 44.8%, with investment grade issuance down 44.1% and high yield issuance down 48.2%. International growth was also strong as the favorable trends of securitization, disintermediation and privatization continue. In Europe, issuance levels rose in the quarter with growth in issuance in the corporate and structured finance sectors. European issuance for corporate entities was driven by growth in both high yield and investment grade issuance, while structured finance experienced solid growth driven primarily by asset-backed securities.
Conditions in the financial services marketplace continued to show improvement, but demand for financial information products is recovering slowly. Growth is expected from independent equity research products during the latter part of the year as a result of the global research settlement between the SEC and ten large investment banks. These ten banks are required to be in compliance with the settlement requirements by August 1, 2004. During the quarter, Standard & Poor’s was selected by several settlement banks to provide independent equity research. The segment continues to make investments in products relating to independent equity research and other new products in the areas of advisor services and indexes.
Revenue related to Standard & Poor’s indices increased as assets under management for Exchange-Traded Funds rose 25.4% to $90.1 billion at June 30, 2004 from $71.9 billion at June 30, 2003. Assets under management at December 31, 2003 were $79.8 billion.
Merger and acquisition activity favorably impacted the sale of valuation services for the quarter compared to prior year. According to Bloomberg Mergers and Acquisitions Database for the quarter ended June 30, 2004, the dollar volume and the number of announced deals involving a U.S. company
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increased 47.6% and 19.3%, respectively, as compared to the second quarter of 2003. The sale of non-valuation services, such as real estate services, litigation support and corporate finance consulting, continues to grow.
The financial services industry is subject to the potential for increasing regulation in the United States and abroad. The businesses conducted by the Financial Services segment are in certain cases regulated under the U.S. Investment Advisers Act of 1940, the U.S. Securities Exchange Act of 1934 and/or the laws of the states or other jurisdictions in which they conduct business.
Standard & Poor’s Ratings Services is a credit rating agency that has been designated as one of four Nationally Recognized Statistical Rating Organizations, or NRSROs, by the Securities and Exchange Commission (SEC). The SEC first began designating NRSROs in 1975 for use of their credit ratings in the determination of capital charges for registered brokers and dealers under the SEC’s Net Capital Rule. The SEC recently began examining the purpose of and the need for greater regulation of NRSROs. In January 2003, the SEC issued a report on the role and function of credit rating agencies in the operation of the securities markets. The report addressed issues that the SEC was required to examine under the Sarbanes-Oxley Act of 2002, as well as other issues arising from the SEC’s own review of credit rating agencies. In June 2003, the SEC solicited comments on a Concept Release that questioned: (1) whether the SEC should continue to designate NRSROs for regulatory purposes and, if so, what the criteria for designation should be; and (2) the level of oversight that the SEC should apply to NRSROs. As the SEC has not yet issued proposed rules or publicly announced the adoption of an alternative course of action, the Company is unable to assess the impact of any regulatory changes that may result from the SEC’s continuing review. The legal status of rating agencies has also been addressed by courts in the United States in various decisions and is likely to be considered and addressed in legal proceedings from time to time in the future.
Outside the United States, the European Parliament has adopted resolutions requiring the European Commission to analyze the desirability of registering credit rating agencies in Europe and the need for registration criteria. In addition, European Union member states are in the process of implementing the European Commission’s Market Abuse Directive, which, depending on how the directive is implemented, could affect rating agencies’ communications with issuers as part of the rating process. Local, national and multi-national bodies have considered and adopted other legislation and regulations relating to credit rating agencies from time to time and are likely to continue to do so in the future.
New legislation, regulations or judicial determinations applicable to credit rating agencies in the United States and abroad could affect Standard & Poor’s ratings’ competitive position; however, the Company does not believe that any new or currently proposed legislation, regulations or judicial determinations would have a material adverse effect on its financial condition or results of operations.
The market for credit ratings as well as research, investment advisory and broker-dealer services is very competitive. The Financial Services segment competes domestically and internationally on the basis of a number of factors, including quality of ratings, research and investment advice, client service, reputation, price, geographic scope, range of products and technological innovation. In addition, in some of the countries in which Standard & Poor’s competes, governments may provide financial or other support to locally-based rating agencies and may from time to time establish official credit rating agencies or credit ratings criteria or procedures for evaluating local issuers.
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Information and Media Services Segment
In the second quarter of 2004, the Information and Media Services segment revenue increased to $194.1 million or 2.5%, while operating profits increased slightly to $24.8 million.
Revenue increased 2.3% at the Business-to-Business Group compared to prior year. According to the Publishers Information Bureau (PIB) advertising pages in BusinessWeek’s North America edition were up by 14.6% for the second quarter with one less issue for PIB, but the same number of issues for revenue recognition. During the quarter the Group launched its first issue ofBusinessWeek SmallBiz. Crude oil prices were volatile during the second quarter due in part to increased Chinese oil demand and increased Middle East supply risk. Oil industry information products experienced growth in the second quarter. The Global Power conference took place in the second quarter of 2003, and there was no comparable event in the second quarter of 2004. Softness continued in the Aviation industry, which was unsettled in 2003 due to weakness in traffic, labor issues and security demands, resulting in a decrease in advertising pages. The Paris Air Show occurred in the second quarter of 2003, no comparable event occurred in 2004.
As of May 2004, total U.S. construction starts increased 10% versus prior year largely due to the continued strength in the residential building sector. However, U.S. non-residential construction declined 2% versus the prior year. Despite a slow start in 2004, commercial building is still expected to see improving trends as the year proceeds. As the non-residential building sector remains weak, revenues from building product manufacturers, construction contractors and service providers declined. Construction publications page yields were higher, while page counts declined versus the prior year second quarter. The McGraw-Hill Construction Network, which was launched late in 2003, continues to gain momentum and drives growth for construction products.
Revenue increased at the Broadcasting Group by 3.5% in the second quarter of 2004. The weak ratings position of the ABC network continues to impact the Group’s performance, however stronger political advertising during the quarter contributed to performance. National advertising time sales, excluding political time sales, declined primarily due to weakness in the Colorado market place. The retailing, automotive and services categories of advertisers contributed to growth while the leisure time and consumer products categories remained weak.
Six Month
In the first six months of 2004, the Company achieved growth in revenue and income from continuing operations. Revenue growth of 6.9% outpaced a 4.1% increase in expenses. Revenue for the first six months of 2004 increased $139.0 million to $2.1 billion. Favorable foreign exchange rates contributed $24.4 million to revenue but negatively impacted income from continuing operations by $1.5 million.
The revenue increase is attributable to growth in the Financial Services segment. Product revenue increased by $2.8 million in the first six months as compared to the comparable period in the prior year, primarily due to an increase in revenue at McGraw-Hill Education. The first half of the year reflects a decrease in adoption opportunities in 2004 compared to 2003 and the seasonal nature of the Company’s educational publishing operations, with the first half of the year being the least significant. Service revenue for the first six months of 2004 increased by $136.2 million an increase of 12.0%, as compared to the prior year, due primarily to the growth in Financial Services. Strong growth in structured finance and corporate finance ratings (corporate finance and financial services)
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reflects continued favorable market conditions, including a low interest rate environment.
In January 2004, the Company sold Landoll, Frank Schaffer and the related juvenile retail publishing businesses (juvenile retail publishing business) part of the McGraw-Hill Education segment’s School Education Group. The juvenile retail publishing business produced consumer-oriented learning products for sale through educational dealers, mass merchandisers, bookstores and e-commerce. In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company reviewed the carrying value of the juvenile retail publishing business net assets as of December 31, 2003 and adjusted the net assets to their fair market value less cost to sell. Accordingly, in December 2003 the Company recognized a loss on disposition and results of operations of $81.1 million, $57.3 million after-tax, or 30 cents per diluted share. Included in the loss were impairments to the carrying value of the juvenile retail publishing business net assets of approximately $75.9 million ($54.1 million net of tax, or 28 cents per diluted share) of which $70.1 million was a write-off of goodwill and intangibles. As a result of the Company’s disposition of the juvenile retail publishing business, the results of these businesses are reflected as discontinued operations for all periods presented. The revenue impact by quarter for 2003 for the juvenile retail publishing business was $15.7 million for the first quarter, $18.5 million for the second quarter, $19.9 million for the third quarter and no impact in the fourth quarter.
In February 2003, the Company divested S&P ComStock (ComStock), the real-time market data unit of the Financial Services segment. The sale resulted in a $56.8 million after-tax gain, 30 cents per diluted share, and an $87.0 million pre-tax gain, which is reflected as a discontinued operation on the income statement. ComStock was formerly part of the Financial Services segment. The disposition and results of operations contributed $87.5 million pre-tax and $57.2 million after-tax or 30 cents per diluted share for the six months ending June 30, 2003.
The divestiture of ComStock is consistent with Financial Services’ strategy of directing resources to those businesses which have the best opportunities to achieve both significant financial growth and market leadership. The divestiture enables Financial Services to bring greater focus to the objective of the investment services business in strengthening its position as the world’s leading provider of independent investment research, analysis, data and products for investment managers and advisors.
Total expenses in the first half of 2004 increased 4.1% primarily due to growth in the Financial Services segment. Product operating related expenses were flat primarily due to cost containment programs at McGraw-Hill Education. Product operating related expenses include the amortization of prepublication costs of $105.2 million, which increased by $6.1 million as compared with the first six months of 2003. Service operating related expenses increased 6.6% due primarily to growth in the Financial Services segment. Selling and general expenses increased 5.4%. Included in selling and general expenses is a credit of approximately $8.6 million relating to the sale leaseback accounting for the divestiture of the Company’s interest in Rock-McGraw, Inc. (See Note 12). Selling and general expenses also increased due to an increase in general corporate expenses as a result of an increase in vacant space which is expansion rental space retained at corporate. Selling and general product expenses increased only 1.3% primarily as a result of cost containment programs at McGraw-Hill Education. Selling and general service expenses increased $38.8 million or 9.5% from the prior year, primarily from the growth of the Financial Services segment. The Financial Services segment also incurred increased rent expense in the first six months of 2004 as a result of its move to
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London’s Canary Wharf. Also contributing to the increase in total expense is the decline in pension income from the Company’s U.S. retirement plans. The decline in stock market performance for the 2000 through 2002 period has negatively impacted the return on the Company’s pension assets. Effective January 1, 2004, the Company changed its retirement plan’s discount rate assumption to 6.25% from 6.75% in 2003. The effect of these changes resulted in a reduction in pension income for the six months ended June 30, 2004 of $6.6 million pre-tax, or 2 cents per diluted share.
Other income for the first six months of 2003 includes $8.1 million of income from the Company’s 45% equity investment in Rock-McGraw, Inc. which was disposed of in December 2003. Additionally, amounts previously categorized as other income within operating expense have been reclassified to operating related expense and selling and general expense under the product and service captions to more accurately reflect their nature.
Interest expense decreased 27.2% to $3.9 million from $5.4 million for the six months ended June 30, 2003. The primary reason for the decrease is the reduction in debt. There was no commercial paper outstanding as of June 30, 2004. In the same period in 2003, average commercial paper borrowings were $550.1 million. The average interest rate on commercial paper borrowings in 2003 was 1.3%. Included in 2004 is approximately $4.8 million of interest expense related to the sale leaseback of the Company’s headquarters building in New York City (See Note 12). Interest income on higher cash levels represented most of the remaining reduction in interest expense.
Income from continuing operations was $241.9 million, a $59.2 million increase over the first half of 2003. Excluded from the results of continuing operations are the results of S&P ComStock and the juvenile retail publishing business, which were disposed of during February 2003 and January 2004, respectively, and are accounted for as discontinued operations. ComStock was part of the Financial Services segment. The juvenile retail publishing business was part of the McGraw-Hill Education segment.
Loss from discontinued operations for the six months ended June 30, 2004 was $0.6 million compared to earnings of $54.8 million for the same period in 2003. In the first half of 2004, the juvenile retail publishing business generated revenue of approximately $3.9 million and operating results were negligible. In 2003, the juvenile retail publishing business generated revenue of approximately $34.2 million and had negative operating results of $3.8 million, respectively. In the first six months of 2003, ComStock generated approximately $11.1 million of revenue. In 2003, the ComStock disposition contributed $87.5 million pre-tax and $57.2 million after-tax or 30 cents per diluted share.
The Company has completed various federal, state and local, and foreign tax audit cycles and, in the first quarter of 2004, accordingly removed approximately $20 million from its accrued income tax liability accounts. This non-cash item resulted in a reduction to the overall effective tax rate for continuing operations for the six months ended June 30, 2004 from 37.0% to 31.3%. The effective tax rate for the comparable period in 2003 was 37.0%. The Company remains subject to federal audits for 2002 and subsequent years, and to state and local and foreign tax audits for a variety of open years dependent upon the jurisdiction in question. The Company anticipates that its rate for the remaining quarters of the year will be 37.0% as in the second quarter.
Net income for the six months ended June 30, 2004 increased $3.9 million to $241.3 million. Included in net income in the prior year was a $57.2 million contribution from the sale of ComStock. Diluted earnings per share from continuing operations for the first six months of 2004 were $1.25 versus $0.95 in the prior year. Diluted earnings per share on net income were $1.25 versus $1.24 in the prior year.
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Revenue for the McGraw-Hill Education segment increased by $5.3 million to $809.9 million and the operating loss was $11.7 million versus $14.6 million for the first six months of 2003. Foreign exchange rates benefited revenue by $7.6 million and had a slightly negative impact on operating profit. The segment’s performance also reflects a decrease in adoption opportunities in 2004 compared to 2003 and the seasonal nature of the business, with the first half of the year being the least significant.
During 2004, the segment realigned product lines between the Higher Education, Professional and International Group and the School Education Group. All years presented have been reclassified. The full year 2003 net revenue reclassification will be $11.8 million for revenue, with the third quarter impact being $3.6 million and the fourth quarter $8.3 million from the Higher Education, Professional and International Group to the School Education Group.
The Global Transformation Project (GTP), which began in 2002, was successfully launched at certain U.S. business units during the first week of April 2004. GTP, which had a pilot launch in Canada in 2003, will support the segment’s global growth objectives, provide technological enhancements to strengthen the infrastructure of management information and customer-centric services, and enable process and production improvements throughout the organization. Expenditures related to GTP were $14.2 million and $21.3 million for the six months ended June 30, 2004 and 2003, respectively. For the six months ended June 30, 2004 and 2003, approximately $10.3 million and $15.3 million impacted operating profit, respectively. The total cost of this project is anticipated to be $180 million.
The McGraw-Hill School Education Group’s revenue decreased 3.0% to $465.3 million in the first six months of 2004 as compared to 2003. The decrease from prior year is a result of the adoption opportunities available and size and timing of open territory opportunities. The new adoption market is estimated to be between $535 - $540 million for the full year, dropping almost 30% from prior year. According to the Association of American Publishers’ year-to-date statistics through June 2004, total adoption and open territory sales for grades K-12, excluding testing, decreased 3.6%. Several states have announced increases in educational funding, as it appears that some of the earlier budget issues have been resolved. These states include Alabama, Florida, Kentucky, Tennessee and Virginia. Conversely, some larger districts and some portions of Ohio and Oregon may experience spending cutbacks due to funding issues. Given the limited opportunities offered by this year’s adoption cycle competition is intense.
The first six months of 2003 reflect a strong performance in the Texas middle school and high school social studies adoptions and a large open territory adoption for elementary and middle school math programs in New York City. The New York City adoption for the second year math purchase is expected in the third quarter of 2004. The School Education Group’s major adoption opportunity in 2004 is in mathematics. The School Education Group currently has five program offerings in mathematics. All of these programs are performing well with the exception of the K-6 basal offering which is experiencing some softness; however, the Group expects to achieve more than a 30% capture rate for the K-12 math adoption. In the first six months of 2004, the Group’s math products performed well in the middle and high school markets, specifically in the adoption states of Florida, North Carolina, Indiana and Alabama. Direct instruction and alternative basal and supplemental reading educational products, such as Open Court Reading, contributed positively to results.Breakthrough to Literacy and Everyday Math also contributed to growth, as did new products for supplemental reading and remediation such as Gear Up andFastTrack.
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Custom contract testing grew in the first six months of 2004 contributing to the segment’s revenue growth. Custom contract revenue continues to increase as states continue to build out their assessments and reporting programs to meet the requirements of the No Child Left Behind Act. Higher custom contract revenue was driven by California, Wisconsin, Connecticut, West Virginia, Colorado, Maryland and the country of Qatar. Expenses were negatively impacted by increased scoring requirements for certain custom testing contracts.
McGraw-Hill Higher Education, Professional and International Group’s (HPI) revenue increased by 6.0% to $344.6 million for the first six months of 2004. Higher education and international products both performed well. School education imprints performed well in Latin America and Europe. The McGraw-Hill Companies continues to improve its position in higher education by growing its college and university business, the least cyclical part of that market. Business and Economics; Humanities, Social Science and Language; and Science, Engineering, and Mathematics imprints all experienced growth domestically. Key titles contributing to the first half performance include:
Trade products and science, technical, and medical titles performed well but could not offset the continued softness in the computer and technology sectors.
Financial Services’ revenue increased to $961.1 million and operating profit increased $71.5 million to $388.0 million for the six months of 2004. Foreign exchange rates contributed $16.3 million to revenue and had a slightly favorable impact on operating profit.
The Financial Services segment increase in revenue and operating profit is due primarily to the performance of structured finance ratings and corporate finance (corporate finance and financial services) ratings, which represented approximately 66.9% of the growth in revenue. In structured finance the continuing favorable interest rate environment led to strong growth in the issuance of U.S. residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs). The growth in corporate issuance is attributable to the favorable interest rate environment and narrowing spreads, which spurred new issuance in the first three months of the year, but dropped off in the second quarter. In addition, revenues from recurring fees for surveillance activities and from customers on annual fee arrangements also contributed to the year-to-year increase in revenue for corporate finance ratings. Bank loan ratings, counterparty credit ratings and ratings evaluation services experienced higher growth rates than more traditional ratings products and contributed to the year-to-year growth.
Total U.S. structured finance new issue dollar volume increased 28.8%, driven primarily by RMBS issuance, which grew 40.3% according to Harrison Scott Publications. While RMBS issuance was strong in the first six months of 2004, the Company expects RMBS issuance to decline towards the end of the year as mortgage rates continue to rise. Issuance for CDOs and commercial mortgage-backed securities increased over the prior year due to the favorable interest rate environment. According to Securities Data, U.S. new issue dollar volume for corporate issuers for the first six months of 2004 decreased 18.1%. The decrease in corporate issuance is primarily due to a decline in investment grade issuances which was down 19.3%, as a result of reduction in refinancing opportunities as issuers have already taken advantage of the low interest rate environment. International growth was also strong as the favorable trends of securitization,
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disintermediation and privatization continued. In Europe, issuance levels rose in the first six months of 2004 with strong growth in issuance in both the corporate and structured finance sectors. Issuance for corporate entities was driven by growth in both high yield and investment grade issuance, while structured experienced solid growth in mortgage backed securities and asset-backed issuance.
Conditions in the financial services marketplace continued to show improvement, but demand for financial information is recovering slowly. Growth is expected from independent equity research products during the latter part of the year as a result of the global research settlement between the SEC and ten large investment banks. These ten banks are required to be in compliance with the settlement requirements by August 1, 2004. The segment continues to make investments in products relating to independent equity research and other new products in the areas of advisor services and indexes.
Merger and acquisition activity which increased over prior year, favorably impacted the sale of valuation services for the first half of the year. According to Bloomberg Mergers and Acquisitions Database for the first six months of 2004, the dollar volume and the number of announced deals involving a U.S. company increased 99.1% and 23.1%, respectively, as compared to 2003. The sale of non-valuation services, such as real estate services, litigation support and corporate finance consulting, continued to grow.
Standard & Poor’s Ratings Services is a credit rating agency that has been designated as one of four Nationally Recognized Statistical Rating Organizations, or NRSROs, by the Securities and Exchange Commission (SEC). The SEC first began designating NRSROs in 1975 for use of their credit ratings in the determination of capital charges for registered brokers and dealers under the SEC’s Net Capital Rule. The SEC recently began examining the purpose of, and the need for, greater regulation of NRSROs. In January 2003, the SEC issued a report on the role and function of credit rating agencies in the operation of the securities markets. The report addressed issues that the SEC was required to examine under the Sarbanes-Oxley Act of 2002, as well as other issues arising from the SEC’s own review of credit rating agencies. In June 2003, the SEC solicited comments on a Concept Release that questioned: (1) whether the SEC should continue to designate NRSROs for regulatory purposes and, if so, what the criteria for designation should be; and (2) the level of oversight that the SEC should apply to NRSROs. As the SEC has not yet issued proposed rules or publicly announced the adoption of an alternative course of action, the Company is unable to assess the impact of any regulatory changes that may result from the SEC’s continuing review. The legal status of rating agencies has also been addressed by courts in the United States in various decisions and is likely to be considered and addressed in legal proceedings from time to time in the future.
Outside the United States, the European Parliament has adopted resolutions requiring the European Commission to analyze the desirability of registering credit rating agencies in Europe and the need for registration criteria. In addition, European Union member states are in the process of implementing the European Commission’s Market Abuse Directive, which, depending on how the directive is implemented, could affect rating
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agencies’ communications with issuers as part of the rating process. Local, national and multi-national bodies have considered and adopted other legislation and regulations relating to credit rating agencies from time to time and are likely to continue to do so in the future.
Information and Media Services segment revenue increased to $370.8 million or 1.9% while operating profits increased 4.3% to $38.5 million for the first six months of 2004 compared to 2003. A slight improvement in the advertising market and continued cost containment continued to benefit the Group. Revenue increased at the Business-to-Business group by 1.5% and at the Broadcasting Group by 4.5%.
At BusinessWeek, advertising pages in the North American edition for the first six months were up 9.4% according to the Publishers Information Bureau, despite the additional bonus issue last year. There was one less issue for revenue recognition purposes in 2004. Advertising pages in the International editions were also up for the first six months of 2004. U.S. energy markets continue to be affected by demand and geo-political issues. Oil industry information products experienced growth in the first six months of 2004. Also in the Business-to-Business Group, the Global Power and Coal Properties conferences took place in the first half. Attendance was up over the prior year at the Global Power conference. Softness continued in the Aviation industry, which was unsettled in 2003 due to weakness in traffic, labor issues and security demands, resulting in a decrease in advertising pages. The Singapore Air Show occurred in the first quarter of 2004 with no comparable event in 2003. The Paris Air Show occurred in the second quarter 2003, with no comparable event in 2004.
As of May 2004, total U.S. construction starts increased 10% versus prior year largely due to the continued strength in the residential building sector. U.S. non-residential construction decreased 2% versus the prior year. Revenues from building product manufacturers, construction contractors and service providers declined as the non-residential building sector remained weak. The construction publications display advertising pages decreased, while page yields increased. The McGraw-Hill Construction Network, which was launched late in 2003, continues to gain momentum and drives growth for construction products.
The Broadcasting Group benefited from strong political advertising during the first six months of 2004 which helped offset the impact of the loss of the Super Bowl which was aired by ABC in 2003. The weak ratings position of the ABC network continued. Preemptions caused by war coverage and the general economic conditions also negatively impacted the performance of the stations during the first six months of 2003, helping comparisons. Year-to-date gross time sales increased 5.3% from prior year, primarily due to political advertising. National advertising time sales, excluding
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political time sales, declined primarily due to weakness in the Colorado market. While the retailing, automotive and services categories of advertisers contributed to growth the leisure time and consumer products categories remained weak.
Liquidity and Capital Resources
The Company continues to maintain a strong financial position. The Company’s primary source of funds for operations is cash generated by operating activities. The Company’s core businesses have been strong cash generators. The Company’s income and consequently cash provided from operations during the year are significantly impacted by the seasonality of businesses, particularly educational publishing. This seasonality also impacts cash flow and related borrowing patterns. The Company’s cash flow is typically negative to neutral in the first half of the year and turns positive during the third and fourth quarters. Debt financing is used as necessary for acquisitions and for seasonal fluctuations in working capital. Cash and cash equivalents ended the quarter at $383.6 million, a decline of $312.0 million from year-end primarily as a result of tax payments, prepublication costs and the repurchase of treasury shares.
Cash Flow
Operating Activities: Cash provided by operations was $28.2 million for 2004, as compared to $275.7 million in 2003. The decrease in cash provided by operating activities versus 2003 primarily relates to tax payments.
Income taxes payable decreased $120.2 million over prior year as a result of higher than usual tax payments attributable to the gain on the sale of the Company’s 45% equity investment in Rock-McGraw, Inc., and a large international tax payment. Also included is a $20.0 million non-cash reduction of the Company’s accrued income tax liability (See Note 13).
Accounts receivable increased only $10.9 million from the end of 2003 primarily from the seasonality of the educational business. Total inventories increased by $89.4 million from the end of 2003 as the Company prepares for its selling season.
Investing Activities: Cash used for investing activities was $109.6 million in the first six months of 2004, compared to $24.3 million in 2003. The change over the prior year is primarily due to the difference in proceeds received from the dispositions in 2004 versus 2003.
Purchases of property and equipment totaled $39.0 million in 2004 compared with $40.5 million in 2003. 2004 spending relates primarily to the facilities consolidation at London’s Canary Wharf, which occurred in the first quarter of 2004. For 2004, capital expenditures are expected to be approximately $140 million.
Additions to technology projects totaled $6.6 million for the six months ended June 30, 2004 compared with $12.7 million in 2003. The decrease is primarily from increased investments in 2003 in infrastructure for the McGraw-Hill Education segment. For 2004, additions to deferred technology projects are expected to be approximately $40 million.
Net prepublication costs decreased to $455.4 million at June 30, 2004, as amortization outpaced spending. Prepublication investment totaled $104.9 million as of June 30, 2004, $15.3 million more than the same period in 2003, reflecting the heavier adoption opportunities in 2005. Prepublication spending is expected to increase over the remainder of the year totaling approximately $260 million as the Company begins to ramp up spending to reflect the significant adoption opportunities in key states in 2005 and beyond.
Financing Activities: Cash used for financing activities was $227.0 million as of June 30, 2004 compared to $222.4 million in 2003. The difference is
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attributable to the increase in the repurchase of treasury shares offset by an increase in the proceeds from the exercise of employee stock options. Cash was utilized to repurchase approximately 2.9 million shares for $223.0 million in 2004.
There were no commercial paper borrowings as of June 30, 2004, a decrease of $526.1 million from June 30, 2003. The Company’s $575 million, 364-day revolving credit facility agreement, entered into on July 22, 2003 allowed the Company to borrow until July 20, 2004, on which date the facility agreement terminated and the maturity of such borrowings could not be later than July 20, 2005. The Company continued to pay a facility fee of five basis points on the 364-day facility whether or not amounts had been borrowed and borrowings could be made at 15 basis points above the prevailing LIBOR rates. The commercial paper borrowings were also supported by a $625 million, five-year revolving credit facility, which expires August 15, 2005. The Company paid a facility fee of seven basis points on the five-year credit facility whether or not amounts had been borrowed, and borrowings could be made at 13 basis points above the prevailing LIBOR rates. On July 20, 2004, the Company replaced the 364-day revolving credit facility agreement and five-year revolving credit facility agreement with a new five-year revolving credit facility agreement of $1.2 billion which expires on July 20, 2009. The Company pays a facility fee of seven basis points on this credit facility whether or not amounts have been borrowed, and borrowings may be made at 13 basis points above the prevailing LIBOR rates. All of the facilities contain certain covenants, and the only financial covenant requires that the Company not exceed indebtedness to cash flow ratio, as defined, of 4 to 1 at any time. This restriction has never been exceeded. At June 30, 2004 and 2003, there were no borrowings under any of these facilities.
The Company also has the capacity to issue Extendible Commercial Notes (ECNs) of $240 million. ECNs replicate commercial paper, except that the Company has an option to extend the note beyond its initial redemption date to a maximum final maturity of 390 days. However, if exercised, such an extension is at a higher reset rate, which is at a predetermined spread over LIBOR, and is related to the Company’s commercial paper rating at the time of extension. As a result of the extension option, no backup facilities for these borrowings are required. As is the case with commercial paper, ECNs have no financial covenants. There were no ECNs outstanding at June 30, 2004 and 2003.
As of June 30, 2003, eighty percent or $420.9 million of the commercial paper borrowings outstanding were classified as long-term. These amounts were determined based upon the Company’s detailed financial budgets and cash flow forecasts and supports the Company’s ability and intent to retain this debt level throughout the next year.
Under the shelf registration that became effective with the Securities and Exchange Commission in 1990, an additional $250 million of debt securities can be issued.
On January 28, 2004, the Board of Directors approved an increase in the quarterly common stock dividend of $0.03, or 11.1% to $0.30 per share.
On January 29, 2003, the Board of Directors approved a new stock repurchase program authorizing the purchase of up to 15 million additional shares, which was approximately 7.8% of the total shares of the Company’s outstanding common stock. The repurchased shares may be used for general corporate purposes, including the issuance of shares in connection with the exercise of employee stock options. Purchases under this program may be made from time to time on the open market and in private transactions depending on market conditions. The Company repurchased 3.1 million shares for $234.1 million in 2004 at an average price of approximately $76.71 per share. Approximately 4.2 million shares have been repurchased under this program through June 30, 2004.
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Quantitative and Qualitative Disclosure about Market Risk
The Company is exposed to market risk from changes in foreign exchange rates. The Company has operations in various foreign countries. The functional currency is the local currency for all locations, except in the McGraw-Hill Education segment where operations that are extensions of the parent have the U.S. dollar as the functional currency. For hyper inflationary economies, such as Venezuela, the functional currency is the U.S. dollar. In the normal course of business, these operations are exposed to fluctuations in currency values. The Company does not generally enter into derivative financial instruments in the normal course of business, nor are such instruments used for speculative purposes. The Company has no such instruments outstanding at this time.
The Company has naturally hedged positions in most countries with a local currency perspective with offsetting asset and liabilities. The gross amount of the Company’s foreign exchange balance sheet exposure from operations is $156.0 million as of June 30, 2004. Management has estimated using an undiversified value at risk analysis with 90% certainty that the foreign exchange gains and losses should not exceed $14.5 million over the next year based on the historical volatilities of the portfolio.
Recently Issued Accounting Standards
See Note 14 to the Company’s consolidated financial statements for disclosure of the impact that recently issued accounting standards will have on the Company’s financial statements.
“Safe Harbor” Statement Under the Private Securities Litigation Reform Act of 1995
This section, as well as other portions of this document, includes certain forward-looking statements about the Company’s business, new products, sales, expenses, cash flows, and operating and capital requirements. Such forward-looking statements include, but are not limited to: the strength of the U.S. and global economy; Educational Publishing’s level of success in 2004 adoptions and enrollment and demographic trends; the level of educational funding; the level of education technology investments; the strength of Higher Education, Professional and International publishing markets and the impact of technology on them; the level of interest rates and the strength of the economic recovery, profit levels and the capital markets in the U.S. and abroad with respect to Standard & Poor’s Credit Market Services; the level of success of new product development and global expansion and strength of domestic and international markets at Standard & Poor’s Investment Services; the regulatory environment affecting Standard & Poor’s; the level of merger and acquisition activity in the U.S. and abroad; the strength of the domestic and international advertising markets; the volatility of the energy marketplace; the contract value of public works, manufacturing and single family unit construction; the strength of the domestic and international advertising markets; Broadcasting’s level of advertising; and the level of future cash flow, debt levels, product related manufacturing expenses, pension income, capital, technology and other expenditures and prepublication cost investment.
Actual results may differ materially from those in any forward-looking statements because any such statements involve risks and uncertainties and are subject to change based upon various important factors, including, but not limited to, worldwide economic, financial, political and regulatory conditions; currency and foreign exchange volatility; the health of capital and equity markets, including future interest rate changes; the implementation of an expanded regulatory scheme affecting Standard & Poor’s ratings and services; the level of funding in the education market (both domestically and internationally); the pace of recovery of the economy and in advertising; continued investment by the construction, computer and aviation industry; the successful marketing of new products, and the effect of competitive products and pricing.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
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Part IIOther Information
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 4. Submission of Matters to a Vote of Security Holders
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Item 6. Exhibits and Reports on Form 8-K
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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